Newton’s Law and the falling Apple

By Ramesh Malayappan

Legend has it that Isaac Newton was sitting under an apple tree and as luck would have it; an apple fell from the tree and stuck his head. That got Newton thinking, “there must be some force that acted upon that apple to cause that fall to the ground and how high could that force possibly go?” Newton reasoned that this force might be universal in nature and thus was born Newton’s Universal Law of Gravitation.

This is a well-known albeit perhaps fictional story that every student of elementary physics gets to learn. In many ways, this story in anecdotal fashion reminds us that all things are subject to the force of gravity, including stocks if you will! So, as an investor, how does this knowledge help us make money? Keep reading.

Investors have flocked to Apple Computer
/quotes/zigman/68270/quotes/nls/aaplAAPL stock in droves and in ever increasing numbers. Just this year alone, AAPL has appreciated by at least 70% and analysts keep upping their target price. Goldman Sachs moved the target price to $810 and says that a major phone redesign as well as expected fast rollout of iPhone 5 to over 100 countries by year end is expected to drive further upside.

In fact, they go on to say that iPhone 5 and iOS 6 will serve as powerful catalysts to earnings into 2013. Goldman Sachs and other firms paint such a rosy picture of Apple’s prospects that at a current price of $700, AAPL appears cheap! It is time for the ordinary investor to forget the fiasco of a Facebook and jump into AAPL right?

Well, not so fast I say. Going long at this price is fraught with risk. The “smart money” went in a long time ago and is ready to head for the exits at the first sign of trouble. It could be a stampede and a retail investor could get crushed in the process!

Early indicators appear to bode very well for Apple after the launch of iPhone 5 and iOS 6 last week. The demand for the new product is so overwhelming that there is a huge backlog of orders and shipment dates for phones ordered over the Internet are being pushed out. This weekend’s store sales is said to have broken all records and all units are nearly sold out. There is potential for millions of new customers (including yours truly), willing to jump onto the Apple bandwagon for the first time in their lives. From an investor standpoint, the sky would appear to be the limit for AAPL. The picture appears to be extremely rosy.

However, let’s step back and take a breath. Even for an iconic stock like Apple, this is too far and too much. The meteoric rise appears to be fuelled by fund managers and institutional investors with enormous sums of money who are buying up the stock with enormous upside hope. What if that does not materialize? Guess what happens? They will start to dump their positions in a heartbeat.

This is too close to the end of the year and no fund manager wants to show a loss in their portfolios should anything go wrong, even by a whisker. There is no room for error. So far, the thought is that nothing can possibly go wrong with Apple and the stock. At least that is how the theory goes. So what could go wrong and why?

First, new iPhone customers are already complaining. Many find the new Maps feature lackluster and error-prone and inferior to Google Maps on Android phones. Surprisingly, the new phone accepts SIM cards across the three carriers that now carry it, meaning that a Verizon SIM will work in the iPhone 5 that is registered to the AT&T network. Was that an oversight or a deliberate design feature? An unlocked phone under contract is almost never offered in the United States.

The wait period for most customers is expected to be long. It is starting to look like the Apple team was in a hurry to rush the phone to market to get an edge over the competition! This is barely days after the product availability and problems are surfacing already. What else might have gone wrong? This company is supposed to be perfect, right?

So how to benefit from a likely fall in AAPL in the coming weeks or months? If lofty expectations are not met, AAPL can easily move south by at least 25% — a huge chunk of change. Should you directly short AAPL? Nah, that is too risky.

One option is to buy PUTS on AAPL and give it enough time to work. The AAPL April 20 2013 690 PUT costs about $5,800 per contract (as of Sep/23/12). Should AAPL fall 25% to $525 from the current price of $700, each PUT contract represents a maximum potential profit of about $17,000. That is about a 300% return in about 6 months, maybe earlier. The advantage of buying such a near the money PUT is that if even a 20% return is acceptable, one can make a quick exit.

Remember, options trading is extremely risky and not suitable for all investors. There is the potential that you could lose your entire $5,800 investment in this scenario. I recommend that you seek the advice of your broker or investment advisor. Good Luck.

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